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5 June

05 June 2015

Investment markets and key developments over the past week

Shares had a rough week as Greek worries continued to weigh, the back-up in global bond yields resumed and worries about a Fed rate hike continued. US shares fell 0.7%, Eurozone shares fell 1.7% and Japanese shares lost 0.5%. Chinese shares were the exception bouncing 8.9% after the previous week’s softness. Australian shares fell 4.8% on the back of the weak global lead, messy Australian economic data and the RBA’s failure to reinstate an explicit easing bias. While global shares are down less than 2% from their recent high, Australian shares have come down by around 8% since their April high. Commodity prices generally fell and the $A fell slightly.

The bond sell off has clearly resumed again led by Europe on the back of stronger than expected Eurozone inflation prompting a further unwind of deflation fears along with increasing signs the US Federal Reserve (the Fed) is on track to raise interest rates around September, with stronger than expected US payrolls bolstering the case for the latter. Our assessment remains that the bond sell off is unlikely to go too far as global growth is below trend, inflation is weak, the European Central Bank (ECB) will continue to be a big buyer of bonds and other countries may still have to cut interest rates again. That said the rise in Eurozone bond yields may be a sign of success as US 10 year bond yields rose through each of quantitative easing mark 1 (by 200 basis points), QE2 (by 130 basis points) and QE3 (by 140 basis points).

The 140% surge in Chinese shares over 12 months and recent gyrations have naturally led some to question whether it’s another bubble that may be close to ending. For example, a cover story in The Economist referred to a “mania” in China’s “overvalued” stock markets. There’s no doubt the Chinese share market has risen a bit too far too fast and parts of it, like ChiNext, do look overvalued. The easy gains are probably over and a period of correction would be healthy. However, the Shanghai composite index on an historic PE of 21 times is still below its long term average and should benefit as further monetary easing comes through.

In fact, The Economist’s cover story on “Flying too high – China’s overvalued stock markets” reminded me of the “Magazine Cover Indicator" which got its start from Business Week’s August 1979 cover on “The Death of Equities” which proved to be a great buying opportunity in shares. Since The Economist cover in October last year relating Europe to Monty Python’s dead parrot Eurozone shares are up 22%.

Negotiations on a “reform for funding” deal for Greece are continuing to drag on with Greece rejecting an offer from its creditors and choosing to bundle up its June 5 IMF payment to be made with other IMF payments at the end of the month. So the deadline has yet again been pushed out. Fortunately, negotiations look to be ongoing. Our base case remains that some sort of deal will be reached in time, but given the stresses within the Greek Government and the need for any deal to be passed by various parliaments it is a close call. So a missed payment later this month remains a high risk. Such a Graccident doesn't necessarily mean that a Grexit is inevitable but Greece will likely continue to be a source of volatility through June. Whichever way it goes though, the threat of contagion to other peripheral countries is low compared to the 2010-12 period as they are in far better shape now and the ECB is buying bonds across Europe as part of its QE program.

Major global economic events and implications

US economic data was good. The ISM manufacturing conditions index rose, non-manufacturing conditions indexes remain solid, construction activity rose strongly, auto sales rose to their fastest pace since 2005, the trade deficit narrowed sharply and labour market indicators are strong with the highlight being stronger than expected employment growth in May and a slight pick-up in wages growth. The run of stronger data, in particular the stronger than expected 280,000 gain in May payrolls, adds to confidence that growth is picking up in the current quarter. The rising trend in wages growth will also help to sustain the US recovery and bolsters the case for a Fed rate hike, probably in September. However, don’t get too excited as the rebound in US growth after the soft March quarter does not appear to be as quick as occurred last year, jobs growth has only just got back to the monthly average seen in the second half of last year, rising labour market participation will likely slow further falls in the unemployment rate and wages growth is coming from a very low base. All of which indicates that while the Fed is on track for a September rate hike, interest rate hikes thereafter will be gradual.

The Eurozone also saw some good economic data, with the composite business conditions PMI revised up for May such that it remains at a reasonable level, retail sales up more than expected in April and unemployment falling more than expected. While the latter is still high at 11.1% the key is that it’s going in the right direction. On top of this inflation rose to 0.3% yoy in May and core inflation rose to 0.9% indicating that the risk of deflation is continuing to recede. However, Europe still has a long way to go to get growth and inflation back to decent levels and so it was not surprising to see ECB President Draghi reiterate the commitment to implement its quantitative easing plans in full (i.e. buying bonds out to September 2016).

In Japan there was a welcome rise in wages growth. However, at 0.9% year on year, it still has a fair way to go before the Bank of Japan (BoJ) can be confident it has broken the back of deflation.

China's official manufacturing PMI rose marginally in May, albeit it’s still at the low end of the range it’s been in for the last few years. However, the slight improvement combined with a gain in average city property prices in May does add a bit to confidence that growth may be stabilising if not picking up. More policy easing is likely required though to be confident.

In India, the Reserve Bank cut interest rates again with inflation being below target and growth in activity slowing in the March quarter. Further rate cuts are still likely. By contrast Brazil raised rates to a record 13.75% to combat inflation.

Australian economic events and implications

Australian economic data was messy. The good news was that March quarter GDP growth was a stronger than expected 0.9% quarter on quarter. Against this though, annual economic growth is just 2.3%, domestic demand remains very weak and data for April looks to be off to a soft start with flat retail sales, a blow out in the trade deficit and a fall in building approvals. The trade deficit blowout may be partly related to bad weather and a slump in the iron ore price to around $US45/tonne whereas it’s now back over $US60/tonne and the fall in building approvals looks like normal volatility. But Australian economic growth looks like remaining sub-par for a while yet as the investment outlook remains weak and the loss of national income due to lower commodity prices continues to impact. There is no reason to get too gloomy as the combination of low interest rates and a lower $A help rebalance the economy, but more help is likely to be required in the form of an even lower $A and possibly another interest rate cut.

While the RBA left interest rates on hold as expected and appears to retain a mild easing bias it was disappointing to see that it did not reinstate a more explicit easing bias. Doing so may have helped push the $A lower. Given the still messy economic outlook another RBA rate cut is a 50/50 proposition, with the August RBA meeting the one to watch.

Finally, there is nothing new in the latest house price data from CoreLogic RP Data. While prices fell in May this looks like a regular seasonal pattern. More fundamentally, while Sydney remains strong, annual price gains are averaging around just 2% in the other capital cities. As such, Sydney should not be seen as limiting any further monetary easing if it’s deemed necessary for the rest of the Australian economy.

What to watch over the next week?

In the US, expect May retail sales (Thursday) to show a decent 1% bounce, a slight rise in consumer sentiment (Friday) and producer price inflation (also Friday) to show a gasoline driven bounce but remain benign on a core basis.

In Europe the main focus will remain on Greece and April industrial production (Friday) is expected to show a bounce.

In China, official economic data for May is expected to show signs of stabilisation in growth. Growth in exports and imports (Monday) is expected to improve slightly but remain negative, retail sales and industrial production are expected to pick up a bit, but investment may slow a bit further (all due Thursday) and credit and money supply growth should show a further improvement on the back of recent monetary easing.

In Australia, the NAB survey (Tuesday) will be watched to see whether the Budget had a positive impact on business confidence and it will be interesting to see whether consumer confidence (Wednesday) hangs on to its Budget related boost from last month. Meanwhile, April housing finance data (Tuesday) is likely to fall back a bit and jobs data (Thursday) is expected to be flat leaving unemployment stuck at 6.2%.

Outlook for markets

Given the combination of seasonal weakness and uncertainties around bond yields, Greece and the Fed the next few months could remain volatile for shares. However, notwithstanding near term risks, the conditions for an end to the cyclical bull market in shares are still not in place: valuations against bonds remain good; economic growth is continuing at a not too cold but not too hot pace; and monetary conditions are set to remain easy. As such, share markets are likely to see another year of reasonable returns.

My year-end target for the Australian ASX 200 index remains 6000. The problem is that Australian shares ran too hard earlier this year and this set the market up for a correction that has been triggered by a combination of softer global markets, the back-up in bond yields weighing on high dividend payers and uncertainty around the Australian growth outlook. The correction will see value restored and this plus continued low rates and an eventual improvement in the growth outlook should set the scene for a renewed run up later this year.

Still low bond yields point to soft medium term returns from bonds, but it’s hard to get too bearish on bonds in a world of too much saving & spare capacity. Central banks won’t ratify a bond crash like in 1994, by raising interest rates aggressively.

The broad trend in the Australian dollar remains down as the Fed is likely to raise rates later this year whereas there is a 50/50 chance that the RBA will cut again and the long term trend in commodity prices remains down. We expect a fall to $US0.70 by year end, and a probable overshoot into the $US0.60s in the years ahead.